ROI-Bonds swept up in leap of faith on AI productivity: Mike Dolan

By Mike Dolan

LONDON, Feb 18 (Reuters) - Treasuries now appear to be riding the artificial intelligence frenzy, as speculation about the speed and scale of AI development spreads across companies and sectors — beating a drum for interest rate cuts if an outsize labor‑productivity boom follows.

That's at least one rationale for the past week's eye-catching slide in U.S. government bond yields. It makes more sense than hanging the move solely on January employment or inflation reports — neither of which offered the Federal Reserve a green light to resume easing.

Yet, as bond yields tumbled across the curve to their lowest levels of the year, Fed rate futures through next year dipped below 3% for the first time in four months. That pricing now implies a third additional Fed rate cut is back in the mix and has invigorated the whole bond universe, which is starting to bet there may be even more in store.

This may simply reflect markets adjusting to the changing priorities of a Fed soon to be chaired by U.S. President Donald Trump's nominee Kevin Warsh, who is due to take the helm in May. The presumption is that Trump's demand for deep rate cuts will then hold more sway.

Up to now, however, investors have not been fully convinced about the impact of a Warsh‑led Fed. A Bank of America survey of global fund managers earlier this month found almost 40% expect his appointment to push Treasury yields higher and weaken the dollar.

So what has changed? Arguably, it's the sharp stock selloff in software and several other sectors, along with a string of AI innovations and breakthroughs at the start of February.

Even Warsh will need cover to step up the pace of rate cuts from what had been expected for months. Like the other Trump appointees to the Fed board, he's likely to lean on the hope of an AI-driven labor‑productivity boom.

In online interviews late last year, Warsh described AI as the "most productivity‑enhancing wave of our lifetimes" and said it would prove "structurally disinflationary," like the expansion of the internet.

If, as the stock market now seems to suspect, AI's impact on corporate fortunes is happening more quickly and comprehensively than expected, then a Fed already inclined to ease again may want to move faster to offset the disinflationary effects of a productivity surge and labor market stasis.

But there's still an awful lot of "ifs" and assumptions doing the heavy lifting in that idea. And precisely because it's still a leap of faith, the current Fed remains agnostic and keener to wait for hard evidence.

FALLING FROM THE SKY

Hiring clearly weakened last year, and the collapse in immigration was at least one factor. January's surprise rebound in payrolls, drop in the jobless rate, and faster wage growth added yet another twist.

Fed doves argue that the sharp drop in job vacancies late in the year both relieved inflationary pressure in the labor market and confirmed their suspicion that companies are now reluctant to hire as AI adoption accelerates and capital‑spending plans ramp up.

Yet Jason Thomas, Carlyle's head of research, remains skeptical about the simplicity of some of the arguments linking AI‑driven productivity and lower interest rates. He argues that neither the historical nor theoretical evidence backs them up.

"AI is not something that falls out of the sky," he wrote, adding that trillions of dollars of annual investments in massive, energy-hungry computers are a rocket for the whole economy.

But if a technology shock triggers such a huge surge in business investment, economic theory suggests real interest rates must rise to induce households to postpone consumption and prevent overheating.

That's what happened during the late‑1990s internet and dot‑com boom, when short‑term real interest rates rose some 300 basis points.

What's more, rapid productivity gains in both capital and labor offer little insulation against high inflation if the investment boom hits resource constraints, Thomas added.

"There's good reason to expect that AI will eventually depress business' operating costs and the overall price level," he concluded. "But with inflation still above target and investment demand surging, action in advance of clear and conspicuous evidence raises the odds of overheating in the interim."

Ultimately, the Fed will have to decide whether a leap of faith is needed now — or much later, given the uncertainty.

But in the interim, AI pressures are no longer just in the realm of the stock market.

(The opinions expressed here are those of the author, a columnist for Reuters.)

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